Time to build capital: Revisiting investment-cash-flow sensitivities

Abstract

A large body of empirical work has established the significance of cash flow in explaining investment dynamics. This finding is further taken as evidence of capital market imperfections. We show, using a perfect capital markets model, that time-to-build for capital projects creates an investment cash flow sensitivity as found in empirical studies that may not be indicative of capital market frictions. The result is due to mis-specification present in empirical investment-q equations under time-to-build investment. In addition, time aggregation error can give rise to cash flow effects independently of the time-to-build effect. Importantly, both errors arise independently of potential measurement error in q. We provide implications and recommendations for empirical work.JEL classification: D21; E22; E32; G31.

Inventory, fixed capital, and the cross-section of corporate investment

“…Poterba (1988), Erickson and Whited (2000), and Alti (2003) point out that because cash ‡ow contains long-run information not properly captured by Q, investmentcash ‡ow relationship can be pronounced for …rms for which measurement error in Q is large, usually small and young …rms, regardless of …nancial frictions. Other explanations unrelated to a …nance channel include a time-to-build friction (Tsoukalas, 2011) and the user-cost-of-capital information (Abel and Eberly, 2011).…”

To What Extent Are Savings–Cash Flow Sensitivities Informative to Test for Capital Market Imperfections?*

“…The authors interpret these results as more powerful and less ambiguous evidence of financial constraints, relative to results obtained within the investment-cash flow framework. By contrast, in an influential paper, Riddick and Whited (2009) generalize the theoretical analysis in Almeida et al (2004) and provide 1 Critiques raised by Kaplan and Zingales (1997), Cleary (1999), and more recently by Erickson and Whited (2000, 2002, Gomes (2001), Cooper and Ejarque (2003), Abel and Eberly (2003), Cummins et al (2006) and Tsoukalas (2011) cast doubt on the validity of investment-cash flow sensitivities as indicators for the presence of capital market imperfections. Broadly speaking these critiques refer to either measurement error in Tobin's Q (which typically controls for investment opportunities) or specification bias associated with the linear investment equation augmented with cash flow.…”

On the Infinite-Dimensional Representation of Stochastic Controlled Systems with Delayed Control in the Diffusion Term

“…We may quote, among others: the problem of growth models with time-to-build in production (see [1,2,4]) or investment (see [19,22]) or with delays in the learning-by-doing process (see [7]); vintage capital models (see [6,16]); advertising models (see [15,17,20,21]). …”